In short, intrinsic value is a measurement of what a company is worth. It’s important to note that this is not the same as the stock price, as a company will often either be undervalued or overvalued.
“Price is what we pay. Value is what we get.”
Understanding the difference between the intrinsic value and market value of a company is incredibly important to long-term success as an investor.
In other words, the stock price is what you are paying for a company, and the value of the company is what you are getting when you buy a stock.
As the name implies, intrinsic value can be somewhat subjective and difficult to estimate. Many different investors have come up with different methods of calculating intrinsic value, and there’s no, one calculation that fits all types of companies.
The intrinsic value is not just its existing cash & assets but it also encompasses all the future cash flow the company will generate going forward. The “future” part is what makes calculating intrinsic value a little complicated.
So thinking logically about this, if the value of a company we’re interested in buying is higher than the stock price it is currently selling for then you are buying that company at a bargain price (a margin of safety) assuming we calculated the intrinsic value correctly of course.
Let’s look at a simplified illustrative example:
- A company has $1,000 cash in the bank and no other assets.
- It stopped doing business so it doesn’t have any future cash flow coming in.
- The company has 100 shares and the owner is selling each share for $5.00
In this example would you buy the stock?
Of course, we should! There’s $1,000 of intrinsic value / 100 shares. So each share has a value of $10 a share and the owner is offering to sell us each share at $5. So we are effectively buying $10 of value for only $5.
Likewise, if we calculated the intrinsic value of a company to be less than its current share price, that naturally increases the risk of the investment as you are investing without a margin of safety.
“The three most important words in investing are margin of safety” — Warren Buffett
It’s important to note that intrinsic value is not a constant number. It will change over time as new information about the company becomes available, most notably when they release new financial statements to analyze.
However, in general, you will find that high-quality businesses see an increase in their intrinsic value over time, and low-quality businesses will either see a decrease in value or be more unpredictable.
That’s why we don’t just look at companies priced below intrinsic value, but specifically look for high-quality businesses that are priced below their value.
The risk of investing in a fundamentally low-quality business even if we purchase it at a price below intrinsic value is that whatever excess value exists at the time of our investment could be entirely wiped out during the time we hold the stock.
There are simply too many methods of calculating intrinsic value for different company types to cover in an article. But Formula Stocks takes care of all that for you.
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While there are of course many other factors that make that possible. Formula Stocks works great as a simple signal service to follow or as a stock screener you can use to find better investment opportunities.
